What are breakouts and false breakouts?
A breakout is basically price getting out and breaching a particular price level on the price chart that was acting as a resistance or support.
If you open up a price chart and notice the price movement, you will find a point on the chart where the price faces difficulty to cross. Price may bounce off from it multiple times before finally breaching it and breaking out from it.
Now, a false breakout, yes you guessed it right, is a breakout that failed to play out.
For instance, consider that a bullish flag pattern is being formed and the price is facing resistance from a particular price level. Price finally moves above the resistance, maybe spends some time outside the pattern but then it falls back into the flag.
This is a breakout that failed to play out and it is what we know as a false breakout. Traders have many ways to justify this and have varied opinions on such false breakouts but read ahead to know why such price action occurs and what the truth is.
Why do false breakouts occur?
The forex market is made up of two types of participants, retail players, and institutional players. The retail players like you and I participate in the market with a relatively tiny amount in comparison to what the institutional players participate with. The amount they have at their disposal is so huge that they cannot trade as easily as we do.
Large capital means bigger positions and in order to build such a large position, they need liquidity in the market to get their orders filled. They get this liquidity from orders placed by other institutional players as well as from the orders the retail players place.
So whenever the price is moving in a range, there will be traders who prematurely place buy orders above the resistance or sell orders below the support, even if the price is still in the range. Hence, at times when we see false breakouts, it is just a liquidity grad by the big players or whales as I like to call them.
Many retail traders have lost money in such price moves and they go on to blame the market and the brokers for the same. They claim that the market and the brokers are conspiring against them in order to take their money.
Even if they knew that it wasn’t that and was actually a liquidity grab they will still not accept it and play the blame game. Instead of doing so, I would sincerely suggest that you find ways to avoid falling for such price action.
There are proven ways to avoid such false breakouts but sadly not much of it is talked about. But you are in luck as I am going to mention 4 ways which will help you avoid losing your money in such false breakouts.
How to avoid getting caught in false breakouts?
1. Wait for the candlestick to close
Whenever you see price in a range or price action inside a pattern and you anticipate a breakout, have some patience. Patience pays.
If you see that the price has crossed the breakout level, do not straight away jump into the trade, you should wait for the price to close either above the resistance or below the support. Take a long trade only if the price closes above resistance and a short trade if the price closes below support.
By doing so you will drastically save yourself from getting caught in breakouts that weren’t going to play out as proper breakouts. You will have noticed wicks being formed that extend outside the range, these are what traders get caught.
There will always be a next candlestick that can be a breakout candlestick and you can always take breakout entries once such price action takes place. So sit back and wait for the candlestick to close and never enter trades while the candlestick is being formed.
2. Wait for price to clear the closest resistance or support too
Let’s suppose you have been tracking a currency pair for some time and see that the price creating a bearish pennant. The price then went on to break out of the pattern as has started moving down. In the path of the price, there is a price level that could act as support. Do you still take the trade? No. You will further wait for the price to break below the support.
The same would be the case if the price breaks out of a pattern or a trendline to the upside and there is a resistance just close to it. These price levels will have some effect on the price action and it might just be a hindrance in the breakouts.
Many times you may not notice it but there is a support or a resistance level that drives price in the opposite direction after breakouts.
Whenever you see a breakout, you need to have a clear path for the price to move into, if there are roadblocks then you should be cautious and wait for the roadblocks to get cleared. This is one important method to avoid false breakouts that are talked about very little.
3. Look for breakouts on the highest timeframe
You might be a trader that trades based on the 1-hour timeframe or the 4-hour timeframe and you spot a breakout taking place on these timeframes. Before you react to this and take an entry, you should zoom out and have a look at the daily timeframe or even the weekly timeframe.
If a breakout is taking place on the smaller timeframes then it is possible that it could be spotted on these timeframes too. If there is a level that has not been broken on the higher timeframe then you should cautious about the trade.
The higher timeframes are always superior and the higher you go, the better the trades are. Here, the method of looking out for the closest support or resistance also applies. If the level has not been broken on the higher timeframes then it could be a hindrance for price action even on the smaller timeframes.
Now suppose, the breakout has played out on the higher timeframe too, do you straight away take an entry? Not yet. While trading breakouts, you need to see how the price played out prior to the breakout. Here we will look for a price build-up and this build-up will be in the form of series of higher highs and higher lows or lower lows and lower highs.
You can spot this build-up on the same timeframe as the breakout took place or you can zoom in and look for it on a smaller timeframe. In this, you can also look for a break of structure.
By this, I mean that, if the price has broken above a resistance, you should go on a lower timeframe and look for price pullback or a retest of the level. Once this price actin plays out, you should then look for price to start creating higher highs and higher lows which indicates that the structure has been broken and that price is in an uptrend now.
Such trades require a lot of patience but if you manage to catch such moves, then you are increasing your chances of being on the right side of the trade as well as making a profit. All this might seem a bit difficult but trust me, if you practice it and test it for yourself then you will see that it is worth all the efforts.
4. Place your stop loss at the right place
What is the right place on the price chart to place stop loss at when trading breakouts? For instance, if the price is moving in a range in a channel and it breaks out of it to the downside, where should the stop loss be placed? It should be placed at the opposite side of the range and in this case, it will be placed at the resistance.
Many traders place their stop loss at a price level inside the range or pattern after they take entry on a breakout. This might make their RRR attractive but it also causes some problems for them. If you place your stop loss somewhere inside the range or pattern, you will become vulnerable in cases of false breakouts.
The price can always break out of the range and fall back into it. In such cases, your trade hasn’t been invalidated completely as of yet as the price hasn’t still breached the opposite side of the range. You should place your stop loss at such a level, which if triggered will make it clear to you that you were wrong in your analysis and weren’t just kicked out by a wick.
If you manage to place your stop loss at the right place then you can save yourself from getting caught in false breakouts. Even if the breakout fails and the price comes back into the range, it can always break out again and you can still be in the trade and ride the breakout.
Have you ever got caught in a false breakout?
I am sure every trader has lost money by getting caught in false breakouts. Have you too?
What is your trade plan or strategy to deal with such price action and how have you developed it to avoid getting caught? I would love to know about your experiences with false breakouts and you can always mention it in the comments section.
Feel free to ask questions too and I will get back to it at the earliest. Share this blog post with other traders you know and let them also protect themselves from false breakouts by acting on all that I have talked about.